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Can Airlines Hold Firm On Capacity?

Newly found pricing power sent airline stocks soaring in 2013, but will the "capacity discipline" story that enabled that strength eventually fall apart

It wasn't long ago when industry overcapacity led to record low fares. Those fares spurred huge losses, ignited battles with unions over givebacks and put many airlines into bankruptcy.

Airlines boost capacity by adding routes, scheduling more flights, using bigger planes and flying longer distances. They might have done any or all of those in the past to gain market share.

More recently, the industry at large reversed the situation by putting fewer seats in the air. Airlines steered away from money-losing routes. Under new chief executives in many cases, they've sought profit rather than share gains.

Industry consolidation has been a factor, reducing the number of competitors. And some analysts see more mergers coming.

The big question on Wall Street is whether airline capacity, measured by "available seat miles," will grow at a slower rate than the U.S. economy. If that scenario plays out, planes will be more crowded, airlines will offer fewer discounts to fill open seats, and average fares — and, theoretically, profits — will edge up.

However, there's reason to be cautious about the long-term outlook for capacity.

Here's why: Recently merged, out-of-bankruptcy American Airlines/US Airways, renamed America Airlines Group (AAL), will be buying new, bigger planes. Southwest Airlines (LUV) will be free to fly nonstop to anywhere in U.S. from Dallas as of October 2014 after the Wright Amendment, which has limited traffic out of Dallas since 1979, expires.

Delta Air Lines (DAL), which has built out Seattle as a gateway to Asia, could also expand domestic flights from that city.

Alaska Air Group (ALK) is expected to continue expanding beyond its West Coast roots. And divestitures required from American will open up new opportunities for low-cost carriers like JetBlue (JBLU), analysts say.

For now, it still looks like airlines won't be their own worst enemies.

"There are fewer sick carriers doing crazy things," Robert Mann, an airline industry consultant, told IBD. "They're all focused on capacity discipline, making every route pay as opposed to going for market share and growing inefficient capacity. That's leading to more pricing power.

A driving force behind that shift, Mann says, has been a change in leadership at almost every carrier.

Airlines have also become smarter buyers of aircraft, says Helane Becker, analyst at Cowen & Co.

"If you look at the industry's past failures, they've ordered aircraft at the top of the business cycle and taken delivery at the bottom," she said in an interview. "Now they're smoothing out capex, there are less peaks and valleys. That has a positive effect on capacity growth.

Capacity Vs. GDP Growth

Many Wall Street analysts are on board, eying a pickup in air travel demand if the economy improves.

"There's plenty additional upside for earnings beyond 2014 on lower capacity and higher fares," said UBS analyst Darryl Genovesi in a Dec. 18 report. "We don't think it would be unrealistic for industry EBIT to double over the next 4-5 years.

That assumes capacity growth 6%-8% below GDP on a cumulative basis, similar to growth over the past five years. However, there's reason to be cautious about the long-term outlook for capacity.

Lower oil prices have been a big factor in boosting industry profits. But airlines need to show restraint in expanding the number of flights because of lower costs, analysts say.

"The most important, absolute driver of industry margins is the level of capacity relative to fuel prices," wrote Barclays analyst David Fintzen in a Dec. 17 report.

John Godyn, an analyst at Morgan Stanley, expects airline stocks to perform well in 2014, so the industry can hold capacity growth to 2% or less. "Our economics team forecasts real GDP growth of about 2.6%, which sets the industry up for another year of margin expansion," he said in a Dec. 9 report. "The current cycle is unique in that it has seen the slowest rate of capacity rebound compared to any prior cycle since deregulation.

The industry trade group, Airlines for America, says planes are being packed fuller amid pricing gains. In 2012, 83.2% of available seats were sold on average, up from 74% in 2004.

"When was the last time you had an empty seat next to you on a plane?" said Becker. "Airlines are now booking an 85% load factor.

The average round-trip domestic fare climbed to $355.75 in 2012, up from $268.73 in 2004. Airline capacity, measured in available seat miles, was 994.5 million, about the same as in 2004.

Passenger revenue per available seat mile (PRASM), a key industry financial metric, has been improving. PRASM includes fares, upgrade fees, baggage fees and other tack-on fees.

Capacity Pressure Rises

While the industry's biggest carriers have guided to capacity hikes below GDP growth, smaller airlines such as JetBlue, Spirit Airlines (SAVE) and Alaska Air are expected to continue adding seats at a faster rate.

Because of their size, the biggest airlines' plans for capacity growth will either calm or roil investor worries, analysts say.

The newly joined American Airlines and US Airways created the largest airline in the U.S., with about 25% of overall domestic seat capacity. Delta and United Continental (UAL) follow with 20% each. Southwest is No. 4 with 19%.

American Airlines says it expects to grow capacity 3% this year, as its new aircraft deliveries ramp up. The company plans capital spending of about $4 billion annually through 2016, above its rivals.

Delta has forecast 2014 capacity growth of flat to as much as 2%. UAL guided to 1%-2% growth in 2014, above some views.

Southwest has said it will hold capacity flat in 2014. Southwest says it will increase capacity in 2015, when its new international terminal in Houston will be completed, if it hits a goal of 15% return on invested capital.

Cities with the most seat availability — such as Las Vegas, Denver, Chicago and New York City — generally have lower-than-average ticket costs. U.S. airports showing price increases include Los Angles, Seattle and Charlotte, N.C.

Delta has added capacity in Seattle, Alaska Air's hub, putting pressure on the smaller carrier. Barclays' Fintzen says the new American Airlines has a large market overlap with United, which could spur a more heated rivalry.

Southwest, which acquired AirTran Airways in 2011, has been retooling its operations in Atlanta, Delta's main hub. Southwest will likely rebuild capacity from Atlanta when it's done, analysts say, and target more business customers.

Southwest and JetBlue, meanwhile, are expected to benefit from Department of Justice requirements for American Airlines to divest takeoff and landing slots at Washington's Reagan National and New York's LaGuardia airports. Bidding for those slots is limited to low-cost carriers.

The Consolidation Tea Leaves

Industry consolidation has helped tame capacity as the number of competitors shrinks and redundant routes of merger partners are streamlined, says a Standard & Poor's report. Future deals will face tough antitrust reviews, as did the American Airlines-U.S. Airways deal.

Even so, with cleaner balance sheets and lower debt loads, "it appears that U.S. airline industry consolidation is not yet complete," says S&P.

There's speculation over a Delta acquisition of Alaska Air as they slug it out in Seattle. One hurdle is that Alaska Air partners with many airlines that might oppose a deal.

JetBlue is expected by many analysts to stay independent. Mann says a roll-up of some U.S. airlines that use Airbus jet airliners — JetBlue, Virgin America, Frontier Airlines and Spirit — is also a possibility.